Key Audit Matters: Examples From an Auditor’s Report

An independent auditor’s report is a formal communication to a company’s stakeholders, like investors and creditors, providing an opinion on whether the financial statements are fairly presented. Recently, these reports have been enhanced to provide greater transparency into the audit process. This enhancement comes in the form of Key Audit Matters (KAMs), a feature mandated by International Standards on Auditing (ISA).

The inclusion of KAMs gives users of financial statements a deeper understanding of the audit by highlighting the areas that the auditor found to be most challenging, subjective, or complex. By shedding light on these specific issues, KAMs offer a window into the auditor’s thought process and significant judgments.

Identifying a Key Audit Matter

A Key Audit Matter is defined by International Standard on Auditing (ISA) 701 as a matter that, in the auditor’s professional judgment, was of most significance in the current period’s audit. Auditors select KAMs from issues they have already communicated to the company’s board of directors or audit committee. Several factors guide the auditor’s determination.

Considerations include areas with a higher assessed risk of material misstatement and the degree of judgment required by both management and the auditor, particularly for complex accounting estimates. The effect of significant events or transactions that occurred during the year is also a consideration, such as major acquisitions, disposals of business segments, or the implementation of a new accounting standard.

Examples Involving Valuation and Estimates

Impairment of Goodwill

Goodwill is an intangible asset recorded on a company’s balance sheet during a business acquisition, representing the amount paid over the fair value of the identifiable net assets. Companies must test goodwill for impairment annually to assess whether its value has declined. This process is highly subjective because it relies on management’s forecasts of future cash flows and the selection of an appropriate discount rate to determine the asset’s present value.

These judgments make goodwill impairment a common Key Audit Matter. The auditor must scrutinize the assumptions underlying management’s cash flow projections. Audit procedures involve comparing the forecasts to historical results, industry trends, and economic conditions, and auditors may engage their own valuation specialists to independently assess the discount rate.

Valuation of Financial Instruments

Many companies hold financial instruments, such as derivatives or certain investments, that are not traded on active markets. Valuing these instruments requires the use of complex models and inputs that are not directly observable in the market, such as volatility assumptions or default rate estimates. The reliance on internal models and unobservable data creates a high risk of misstatement and makes the valuation of these instruments a frequent KAM.

The auditor’s work involves understanding and testing the company’s valuation models, assessing the reasonableness of the inputs, and comparing them to available external data. Auditors will use their own independent pricing models or engage specialists to provide a separate valuation to compare against the company’s figures.

Allowance for Credit Losses

Companies that extend credit to customers, such as banks with loan portfolios or businesses with accounts receivable, must estimate potential losses from customers who may not pay. Accounting standards require companies to establish an “allowance for credit losses” based on expected future losses, not just past-due accounts. This forward-looking approach requires judgment in forecasting economic conditions and their impact on customer defaults.

The subjectivity involved makes this area a prime candidate for a KAM. Auditors must evaluate the models and assumptions management uses to develop the estimate, which includes analyzing historical loss data, evaluating economic forecasts, and testing the integrity of the data used in the models.

Examples Involving Complex Transactions

Revenue Recognition from Complex Contracts

Recognizing revenue can become complex, particularly for companies with long-term contracts in industries like construction, aerospace, or enterprise software. Revenue is recognized over time as the company fulfills its performance obligations. Identifying these distinct obligations within a single contract and allocating the transaction price to each one can involve significant judgment.

This complexity is why revenue recognition is one of the most frequently cited Key Audit Matters. An auditor must gain a deep understanding of the company’s contracts to evaluate management’s application of revenue recognition rules, which includes inspecting contract terms and testing the methods used to measure progress toward completion.

Accounting for Business Combinations

When one company acquires another, the transaction, known as a business combination, requires complex accounting. The acquiring company must allocate the purchase price to the various assets acquired and liabilities assumed, based on their fair values. This process involves identifying and valuing intangible assets, such as customer relationships or brand names, that were not previously on the acquired company’s balance sheet.

The significant estimates required in this purchase price allocation make business combinations a common KAM. Another complex element can be contingent consideration, where the final purchase price depends on future events, and the auditor’s response includes examining valuation reports and testing key assumptions.

Provisions for Litigation and Claims

Companies face legal disputes, regulatory investigations, or other claims that could result in a future financial loss. Accounting rules require a company to record a provision, or liability, for such a loss when it is probable that a payment will be required and the amount can be reasonably estimated. Making this determination is fraught with uncertainty and requires significant judgment.

The uncertainty in predicting the outcome of legal matters makes provisions for litigation a frequent KAM. Auditors must evaluate the company’s process for identifying and assessing potential claims by examining correspondence with legal counsel and analyzing the facts of the case to determine if management’s judgment is supported.

Distinction from Critical Audit Matters

Readers of financial reports in the United States may be more familiar with the term “Critical Audit Matters” (CAMs). CAMs are the U.S. equivalent of KAMs and are required in the audit reports of public companies by the Public Company Accounting Oversight Board (PCAOB). While the objective is similar, the requirements originate from different standard-setting bodies.

KAMs are mandated by the International Auditing and Assurance Standards Board (IAASB), which sets standards for many countries. In practice, there is a significant overlap in the types of issues identified as either a KAM or a CAM, as both frameworks direct auditors to focus on areas of high risk and significant judgment.